Cable: parity is still a long way off but $1.40 beckons

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Since 1982, cable has been contained by the 1985 low of GBP/USD1.0790 and the 2007 high of USD2.0798. The bulk of this time cable has remained within a narrower 1.40 to 1.80 trading range.

These statistics illustrate how significant it would be if the pound were to slip to parity with the dollar this year. They have not, however, stopped some commentators speculating about such an event.

The problems affecting the pound are well documented. The appalling truth is that a combination of low growth expectations for the UK economy and a crippling budget deficit have opened the risks of a funding crisis (if the government does not get the budget in order) or a double dip recession (if too much austerity is introduced too soon).

There may exist a narrow policy path the government could steer that would allow for improved fiscal management and moderate growth but, since the chances of a hung parliament are failing to disperse with just 2 months to go before the favoured election date, it appears likely the new government will lack the backing to take difficult decisions.

The size of the budgetary problems facing the US and UK governments are not vastly different. According to the Bloomberg survey, economists are forecasting a UK budget deficit at 8.7 percent of GDP in 2009 rising to 11.6 percent in 2010. The US budget deficit is forecast at 10.20 percent of GDP in 2010 but a fall to 9.4 percent of GDP is forecast for 2011.

The first constraint on budget reform in the UK comes from lacklustre economic activity. Admittedly Q4 GDP was revised higher to 0.3 percent q/q.

However, this was largely due to government spending, a course which will should go into reverse this year. The risk that the UK could fall back into double dip recession this year not yet been fully averted and the fragile nature of the UK recovery will make aggressive fiscal reform harder to implement.

The second hurdle facing budget reform is the general election and the looming threat of a hung parliament. While it can be argued that many European countries have coped well with coalition governments, other countries have not. A series of weak coalition governments in Belgium and Italy left legacies of large public debts.

The chances that the budget deficit will not be properly tackled effectively after the general election thus seem high. To make matters worse this increases the chances of a credit rating downgrade. In May last year S&P revised the outlook on UK debt to negative from stable.

A clear program of budget reform is needed to kick this threat into touch. While a downgrade is still not viewed as a serious threat, if it were to happen it would inevitably push bond yields even higher and weigh further on government finances.

In terms of growth the US economy is unlikely to shine brightly this year. However, is it likely to grow faster than either the UK or the Eurozone. The Bloomberg survey forecasts US growth at 3 percent in 2010 compared with 1.2 percent for the UK. Consequently, its central bank is likely to hike rates sooner.

Expectations of a rising rates differential in favour of the USD are likely to exaggerate the softer tone of cable in the approach to the first Fed rate hike; likely in Q3. It may be too soon to call a move to parity in cable this year, but a fall to USD1.400 or even the 2009 low at USD1.3753 is possible if a hung parliament follows the election.